I am going to Target to get some stuff. I will get your Lactaid milk there. How much are you willing to pay?

OR

I am going to Trader Joe’s to get some stuff. I will get your Lactaid milk there. How much are you willing to pay?

But I digress.

For those who are not aware, Lactaid is the brand of lactose reduced milk ( reduced using lactase enzyme). It is generally priced twice at much as regular milk. Instead of buying Lactaid, one could buy regular milk and lactase and mix it themselves. But what Lactaid offers is convenience and for the limited segment that wants milk despite their intolrenance and values convenience. So a higher price makes sense.

Lactaid is a national CPG brand, available in most stores. So why is it priced higher at Trader Joe’s?

Another argument is cost based. Target, a bigger retailer, has pricing power with suppliers. Since it can negotiate a lower price it can charge lower price to its customers. True but the cause and effect are reversed. Target wants to serve lot more customers that have lower willingness to pay. Once they decided the price they work with suppliers to bring the cost down. Not the other way. Think about prices of other products (granted not same brand). Does the cost argument holds?

One line of argument is, it is not just the product, it is the store experience. The price of store experience is built into the milk. Partly true. Then you must run the behavioral experiment I stated in the beginning.

The answer, as in most pricing cases, starts with the customer.

A Trader Joe’s customer goes there for different reasons than they go to Target (likely same customers but they hire the stores for different reasons). They go to Trader Joe’s for its unique product mix, experience etc. but definitely not for getting Lactaid milk. If I remember correctly that is the only major CPG brand I have seen at Trader Joe’s. Most of the product mix is made of store brands or smaller regional brands.

Those customers seeking to buy Lactaid at Trader Joe’s is looking for convenience. They are at the milk aisle for the rest of the family and want to complete their milk shopping list by avoiding one more trip to another store or its milk aisle.

There are likely not many such customers (most likely TJ’s customers are Target customers as well). So for that limited segment that values convenience and needs a specific product, the willingness to pay is higher.

Since they can charge this higher price they are likely willing to pay higher price to suppliers to stock the milk in their shelves.

No customers. No products.

Price always comes first then costs. And for pricing, customers and their needs come first, then everything else.

Explaining why it costs even more at Whole Foods is left as an exercise to the reader.

Homeownership – the American Dream. The one that contributed significantly to the Great Recession and is still responsible for the slow recovery we are seeing. There is some change in this love to own a home, among some demographics, but not much to call it a shift.

To explain why we still prefer buy vs. rent will take a book, so let us keep it brief and look at the errors we commit in our thought process. There was an article in The Washington Post that wrote about a research that found, “Average American’s don’t think like Economists”.

That explains a lot about our love for buying homes. I should add, when it comes buying or selling their own homes most economists don’t think like economists.

The Seller pays all the realtor fees- The first thing any realtor will tell a prospective homebuyer is, “you don’t pay me anything, the seller pays me“. Conflict of interests aside, how does the seller really pay? It does not come from a different pot the seller has. The seller pays by including it in the price of the house.A moment’s reflection will convince you that the day you sign the 2564th document they thrust in front of you during closing, you are down 5-6%. In other words even if you sold the house the next day you will lose 5-6% of the price you paid.

Rent is down the toilet – Rent is an expense. By extension every expense we make is down the toilet. Besides this ignores the fact that your interest payments, most of your monthly mortgage payments are just that in the first few years, are down the toilet too. Interest is the rent you pay to use the bank’s capital to buy the house.

Interests are tax deductible, rent is not – True and this could be used as a another point to bolster the case, “rent is down the toilet”. First there are limits on mortgage interest tax deductions. Second, renters indirectly get the advantages of the tax deduction.
When you rent a home or apartment recognize that they are owned by somebody who is paying mortgage interest on that property. Because of the tax deduction the cost to own is reduced and hence more are willing to get into the renting business. As more such owners buy to rent it out, the supply of rental properties increases and hence the price decreases. If there were no deductions fewer people may own rental properties and the decrease in supply will push up rent. Either way renters get part of the benefits of mortgage tax deduction.

Prices will always go up – There is enough data published by Case-Shiller that says prices don’t go any faster than rate of inflation. We all suffer from optimism bias, ignoring the downside and giving higher likelihood to favorable scenarios.
Even if it did, what does it mean to us to take advantage of the new higher prices? We need to sell the house first. Where would we live then and what would be the costs? If your home price went up so did the whole neighborhood, city, and state. Unless you are ready to move to a low-cost state there is no upside to the home price increase.

Opportunity cost of down payment – This is huge for those buying houses in Bay Area. When you sink 20% of the price of the home in one illiquid asset you are losing out on the opportunity cost of investing the same capital in any diversified fund.
While realtors tell you, “when stock market goes down you are left with nothing to show for but even when your home prices go down you have a place to live”, you need to ask
– will my mortgage payments stop? No.
– Is my down payment safe? No, that is wiped out with just 10-20% down swing in home prices.
– will i still have job in the same neighborhood? Unlikely.
If the stock market is wiped out, will be home market be any better? They are not completely uncorrelated. At least you get diversification when you invest your down payment in a broader market.

Locking in my “rent” for next 30 years – This is usually stated as post-purchase rationalization, “at least I know what my payments will be for the next 30 years”. If the economy goes south, you are liable for the same level of payments even if the market prices for rent are lower.
If indeed rent goes up, then you need to realize that you are maintaining the same quality of life at a higher cost even though there is no additional money flow. In other words you could rent the home out to take advantage of higher rent and reduce your standard of living by renting a lower quality place for you. The net is there is no advantage in locking in payments.

Unlocking equity - Homeowners repeat this phrase as if it were a self-evident truth. They speak as if they sold part of the house and cashed out without really giving up that part of the house. The basic accounting equation isAssets = Liabilities + Equities
When you buy the home it is added to the asset column at the price you paid and the mortgage you took is added to the liabilities. The down payment is added to equities column. The two sides of the equation are matched.
When market price for homes goes up it does not really do anything to the asset side unless you are doing mark-to-market accounting (which we don’t). If we did that then the assets column will go up. The increase in left side of the equation is balanced by adding the same amount to the equities column.
What you do when you take out a home equity loan is move some or all of that increased equity to liabilities column.
The net is, you are liable for the additional loan you take out. It is not like you are issuing new stocks to convert the asset class to cash.

There you have it, the seven errors in our thinking that leads us to prefer buy over rent.

Other articles:

Home Staging - Why our willingness to pay is higher with staged homes?

In a WSJ interview Wal-Mart’s chief of U.S operations says this about Wal-Mart’s attempt to re-design its stores,

WSJ: Is Wal-Mart as focused as it needs to be on offering the lowest possible prices?

Mr. Simon: A lot of things have distracted us from our pricing mission. We got enamored with presentation as an example. We walked people through our [remodeled] stores and they were gorgeous.

But they cost more. And if you spend more on your building, your prices can’t be as low as you want them to be.

“Every Day Low Price” can’t come from the supplier because they have to make money too. “Every Day Low Price” has to come from every day low cost, which means we have to operate for less.

Sustainability and some of these other initiatives can be distracting if they don’t add to every day low cost.

There are two claims made here that I believe the interviewer should have pushed Mr.Simon on but did not.

If you spend more on your building, your prices can’t be as low as you want them to be.

Sustainability and some of these other initiatives can be distracting if they don’t add to every day low cost.

I will discuss the first point in this article and defer the second for a future article.

Better design and presentation does not mean the sourcing costs (what Wal-Mart pays to suppliers) go up. So why should the customers offset that cost in the form of higher prices?

If the design changes are already made and if there are no recurring costs to keep-up the design, the costs are sunk. So why do they matter?

Unless of course Mr.Simon is looking at an accountant’s definition of Cost Of Goods Sold (COGS) which includes in it a share of all fixed costs. To an accountant preparing the company’s financial statements, ever bar of soap and bottle of shampoo must be assigned its share of the building cost, employee cost, utility cost etc.

It is due to the quirky accounting rule of how costs are matched with inventories and how inventories are moved into expenses as Cost of Goods Sold.

But the accountants do not run businesses, set prices or make business decisions. They report on the business’ performance with just enough clarity and obfuscation at the same time.

A business cannot spend more on a building and expect to pass on the costs to customers in the form of price increases. Before spending money to improve the aisles, they should have estimated whether the improvements will nudge their customers’ willingness to pay higher and whether they can generate enough profit to justify the costs.

Incremental profit need not come in the form of higher prices, it can be in the form of increase in sales from new customers. Better design could bring in new customers who otherwise would not have stepped into the store.

To say, “If you spend more on your building, your prices can’t be as low as you want them to be” is neither true nor relevant here.

As an important side point, when a store spruces up and improves its design and shopping experience will the willingness to pay of its customers go up?

The answer will take us through the path set forth by Thaler on Mental Accounting and Consumer Choice. It starts with the story of you relaxing in beach and thirsty for an ice cold drink.

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We are big fans of Harry Potter books and love seeing the movie version as well. Today was our movie day to see the The Deathly Hallows Part-1.

I am not the most spontaneous of human beings so I had the AMC discount tickets purchased at $7 a ticket. As you might know the rules of such tickets, these are not valid for the first two weeks of the movie unless you are willing to pay an additional $1.50.

I reasoned, the $21 I spent on pre-purchased discount tickets are sunk and the only decision was whether or not to spend the additional $4.50 to see the movie today. I decided to go any way to make use of the rare weekend break.

At the box office I found out that the tickets were actually $6 for the show time we went to. Regardless of that low price, the kid at the box office said that if I wanted to use my discount ticket I still should pay $1.50 more per ticket.

The $7 tickets have unlimited life but can only be redeemed at AMC.

What is the rational move?

Pay just $4.5 and use the pre-paid discount tickets? OR

Pay $18 and buy the ticket at current price?

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Consider this scenario – You are at a casual dining chain restaurant like Chilis, Applebee etc. You are done with your meal, paid your check and finishing off your last drop of coffee. Then the manager walks by, asks you about your experience and voila gives you not one, not two, but three $10 coupons good for your future visits. The coupons require a minimum of $20 purchase, can be used one per visit and have a three month time period. Coupons are valid at all locations.

Are you more likely to visit the restaurant in the future because you received three coupons than if you had received just one coupon?

The case of single coupon has been studied at length in the marketing literature and yes it does work in generating repeat visits. Whether the coupon driven visits are profitable or not is a different question and it depends on percentage of customers who would not have visited without the coupons. Coupon driven visits are profitable when

(ave tab per visit less coupon ) * % who visited only because of coupon

>

(coupon amount) * % who would have visited anyway

Suppose one coupon is good for business in generating incremental revenue, are three coupons better?

The answer comes from Prospect Theory and Mental accounting. When presented with one $10 coupon with strict expiration date, letting the coupon expire will create a sense of loss in the minds of customers. When presented with three such coupons, even though the coupons are not additive, customers will see the value as additive. Not using any of them will cause a greater sense of loss (loss curve is convex – prospect theory). A customer who lets all three coupons expire will have greater sense of loss than the one who lets the single coupon expire. So those who receive three coupons are more likely to revisit at least once than those who received just one coupon.

Since this increases percentage of customers who visit because of coupons, the restaurant stands to gain from giving more than one coupon to the customer who is less likely to visit otherwise.

Finally, what if the customer decides to use all three coupons? At an average restaurant tab of $50, that is $120 incremental revenue (since all restaurant costs are sunk, this goes straight to bottom line).

If one coupon is good, three are indeed better!

You do not have to settle for the theoretical explanation – this is easy to experiment. Do A/B tesst and see if this works for your business.

Whether this trains the customer to expect coupons and reduces their reference price is a topic for different post.

Shiller (of Case -Shiller index) wrote in The New York Times about why home prices fall slowly instead of crashing and why the prices may continue to fall. This is a great explanation of the averages and the reasons for slow decline. Two questions occur to me:

Why does a homeowner start with a very high list price even though the market price (based on comparable homes) is lower?

Why are homeowners willing to let go an offer only to settle later for the same or lower price?

The reason for the high list price can be attributed to endowment effect. People tend to value things they own more than the things they do not. This is nicely demonstrated in a video by Dan Ariely. There is considerable emotional connections that get translated into higher utility and hence a higher valuation. In addition to this people do not consider opportunity cost of carrying the home for longer time. This results in initial high priced listing despite the fact that comparable houses in the neighborhood have been in the market for a much longer time and are currently priced lower than this house. Unfortunately buyers do not share the same emotional value hence houses end up sitting in the market longer.

The reason for rejecting reasonable offers during the initial days only to settle for same or lower price later is due to mental accounting that ignores the opportunity cost of carrying the home longer. Opportunity cost here includes additional mortgage payments, carrying costs and most importantly lost revenue from capital tied up in the house. Even if they considered opportunity costs, homeowners overestimate the chances of getting better offer and underestimate the time they need to wait for such an offer. Due to high initial price, a low offer will also look substantially lower.

The net result is prices not reflecting what the market is willing to pay. Hence the slow decline of home prices.